The taxman cometh for fund investors’ money

Prepare to share more of your stock market gains with the government

By

JonnelleMarte

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NEW YORK (MarketWatch) — As taxpayers crunch the numbers to see how much they’ll owe to Uncle Sam this year, some may be overlooking a key area: their mutual funds.

Analysts and advisers say it may pay for fund investors to take a closer look at how much of their returns are going to the tax man — especially at a time when Americans are adjusting to higher tax rates and when taxable payouts from mutual funds are likely to become more common.

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“People tend to just pay attention to their total return but that’s not really the bottom line,” says Russel Kinnel, director of mutual fund research at investment researcher Morningstar Inc. “The bottom line is after the fund company and Uncle Sam take their share.”

Taxes haven’t been a major concern for fund investors in recent years because many fund managers have been offsetting any taxable gains with losses carried over from the financial crisis.

But now that the market is hovering near five-year highs and many funds are back to their pre-crisis levels, fund managers are running out of losses to offset those gains, forcing them to pass along the distribution — and associated tax bill — to investors. (Mutual funds are required to pass on their gains to investors each year, and investors have to pay taxes on that distribution when they receive it.)

Tax consequences

Some investors will see a bigger tax hit from their mutual funds — and other income — because of new taxes being introduced this year. For instance, a new 39.6% top tax bracket applies to earnings above $400,000 for single payers and above $450,000 for married couples. And a new 3.8% Medicare surtax on investment income will affect individuals making more than $200,000 and married couples earning above $250,000.

While some managers try to minimize the tax consequences of their investment decisions by avoiding dividend-paying stocks, holding shares for more than a year to capture the long-term capital gains rate, or offsetting stock gains with losses, it’s not a mandate all managers keep in mind. Indeed, for funds with terrific returns, a higher tax bill may not be enough to send investors running.

Still, seeing taxes are taking a big bite out of a fund that is already disappointing could be reason enough to get out. Some people may be better off switching to index funds, which tend to be more tax efficient than actively managed funds because stocks are bought or sold less often, says Leslie Thompson, a financial adviser at Spectrum Management Group in Indianapolis.

Exchange-traded funds can also be more tax efficient because they don’t have to buy and sell stocks in order to make allocation changes the way mutual fund managers do, Thompson adds.

Actively managed funds, however, can have more taxable income depending on a manager’s trading activity. That’s why some investing pros gauge the tax efficiency of a fund by looking at its portfolio turnover, or the rate at which a manager replaces the holdings in the fund.

A turnover of 100%, for instance, means that the manager sold enough stocks to replace every holding in the fund at least once; 200% means each stock could have been replaced twice, and so on. The more a manger sells stocks, the more likely investors will have to pay taxes on holdings that have risen in value, says Todd Rosenbluth, a mutual fund analyst with S&P Capital IQ.

Keep what you make

When returns are low, taxes can make all the difference between a positive and negative return. Take the $1.3 billion JP Morgan International Equity Fund
VSIEX, -1.44%
which invests primarily in companies in Europe and Japan. The fund returned an average 0.6% annually over the past five years, beating other foreign large blend funds in Morningstar’s category by almost two percentage points. But after taxes, an investor in the 35% tax bracket would have lost an average 1.6% a year over that same period, according to Morningstar. JP Morgan declined to comment.

Other times, tax woes could be associated with a seemingly positive trait — high income. While the income stream produced by dividend paying stocks can appeal to retirees or other yield hungry investors, it also means those investors have more taxable income.

Consider the $1.6 billion Henderson Global Equity Income Fund
HFQAX, -0.87%
, which invests in dividend paying stocks and sports a 6.3% yield. Before taxes, the fund returned 1.9% a year annualized over the past five years. But after taxes are taken into account, those returns become an average yearly loss of 1.8%. Henderson did not respond to requests for comment.

That’s not to say investors should shun funds paying attractive yields or dump a fund because it isn’t tax efficient. Analysts point out that the tax hit will vary depending on your individual situation, and the impact could be less for people in lower tax brackets. Plus, investors in tax-deferred retirement accounts have no reason to be alarmed.

“You don’t want taxes to necessarily dictate what you’re going to do,” Thompson says. “But you want to be aware of what you’re getting into.”

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